Q&A With Dan Weiskopf: Inflation Concerns And ETFs (Part I)

Dan Weiskopf, along with his partner Daniel Faucetta, are Principals of Global ETF Strategies (GES) an Asset Management firm which has been managing ETF portfolios since 2004. Prior to that time, Dan managed a hedge fund for 8 years which gives him a unique perspective as an ETF Strategist and Portfolio Manager. Dan also writes about ETFs frequently and has a regular monthly ETF Email. Recently, Dan wrote a piece titled “100 Ways to be long the inflation trend” using ETFs and has a new Tactical Portfolio Strategy called Positive Return Inflation Strategy (PRIS). Additional information about his strategies and white papers can be found here. We checked in with Dan after reading the piece to get further insights into what he was thinking regarding the future of inflation as well as his thoughts on how to fight this with exchange-traded funds.

ETF Database (ETFdb): How serious of a threat is inflation?

Dan Weiskopf (DW): The answer depends upon whether we are talking about inflation in the context of CPI at 2.5% or inflation that affects how people really live? Either way, however, the trend looks to be high but the impact on people’s standard of living is dramatically different and the sooner this reality is acknowledged, the more prepared people will be.

Put it this way — if you were to take three Polaroid pictures of US economy over the past three decades you would find very little change to inflation as defined by CPI, but the problem is that the Polaroid camera has been replaced with a digital camera that shows change at a faster rate and the US is no longer self sufficient; so the pace of change is becoming more important. Using this same analogy, we would also say that the details that people see when they are looking at a digital or Polaroid picture reminds us that the CPI metrics which define inflation have fading relevance. Global inflation is serious, especially in China and India, two critically important growth engines for the future; inflation in these countries is between 5-10%. Looking at a Polaroid picture of inflation as it slowly develops only provides a small narrowly focused, blurry picture of a fond memory. It is no wonder that the Polaroid camera was viewed as a toy and is now obsolete. We need to look at a digital picture with a panoramic zoom lens.

The point is that we believe that the direction of inflation has permanently changed course in the context of purchasing power and if people are looking at CPI through a Polaroid picture they are not looking at a sharp picture of the issue. Ultimately, this will be a problem because we believe that people will be surprised down the road when the picture fades and basic goods like food, heat and transportation are much more expensive [Inflation Fighting ETFs Back In Focus].

People have been living in denial for so long that we think the degree of change from 2.5% to 4% would be viewed as shocking. We are concerned that America’s dependence abroad, specifically the emerging markets, has set us up for a dramatic change in the rate of our CPI. We see the seriousness of the issue broken down into three categories: First, short and long term trends towards higher inflation are inevitable. Second, the frame of the problem and who it will affect; and third, the solution to inflation issue is to buy it not fight it.

We see higher inflation trends as inevitable both in the short and long term because capitalism is intoxicating and the economic progress in the emerging markets is leading to a permanent paradigm shift towards higher inflation. In the short term, we look at CPI at 2.5% in the US and wonder how it has any place to go but up. There is no denying that food and energy prices are high today and arguably will continue to trend higher for the foreseeable future and possibly beyond 10 years. We agree that high unemployment in the US is holding inflation back, but lower wages in the US and higher wages in the emerging markets means that we have to be prepared to absorb additional costs when the average American’s salary is not keeping up with true cost of living adjustments. Unfortunately, we see this trend as a potential long term phenomena and one that in the context of higher rates makes this shift very difficult to absorb for the average American.

The second problem is that people in the US often look at inflation solely in the context of CPI and how this metrics has performed for the past 30 years. We simply want to point out that framing a static rate of inflation at 2.5% is like continuing to use that Polaroid camera. Our concern is that by this assumption people automatically are ignoring the issue and its relevance. This is a problem; especially in the context of any long term outlook which is true for everything from higher rates on US Treasury Bonds to anyone who has a variable credit outstanding. It is a problem for pension plans which match liabilities to CPI. We know that 76 million babyboomers expect to retire within the next 30 years and most of these people will live longer than the prior generation. Health care costs continue to spiral higher and are critically underrepresented in CPI. We are concerned that by not addressing the issue today in the proper framework ultimately we will just continue the deficit spending which will then add to the inflation issue. Ultimately, this makes for a serious problem for everyone alive in America in the future. I am concerned that in the year 2030 taxes will have to be very high.

By not framing the inflation trend properly, people will have undersaved for their retirement. There is a material compounding effect by not estimating inflation correctly. So our answer to the inflation reality is to align a portfolio with the most positively correlated inflation asset classes and buy the trend. Typically as a last resort, people have looked to Treasury Inflation Protection Securities (TIPS), but with the evolution of ETFs there are many asset classes that are investable which are more highly correlated to inflation [see Beyond TIP: Ten ETFs To Protect Against Inflation]. In addition, since we are moving in the direction of uncharted waters a dynamic approach makes the most sense. In this environment, we need the digital camera to monitor how inflation is changing globally and the stage of cycle that we are investing in. People too often assume that inflation is linear.

ETFdb: It seems like we’re in a “boy who cries wolf situation” with constant warnings that inflation is coming–but so far inflationary measures have been pretty tame. You seem to think that inflation is coming, and perhaps already here if we look at the emerging markets.

DW: I get your skepticism that CPI in the US has been “tame”, but at best it would seem that this definition is very narrow. When you exclude or minimize food and energy costs, you are missing out or diluting a real material aspect of cost of living. I understand that central bankers have their own definitions, but I am not sure what environment exists where a family’s food and energy expenses increase 20% to 30% and such costs are excluded from a measure of inflation.

Simply put, I think the academics in the central bank have rigged the game with their definition, but even so, four factors are about to change in our opinion. First, the CPI definition is highly dependent on real estate, which is 42% of the index. We firmly believe that the bubble that burst in real estate has had a tremendous downward pressure on inflation the past 2 yrs; especially in the context of CPI, but in the best case scenario we hope that real estate stabilizes and under this circumstance this downward pressure would reverse and further accelerate the inflation trend we envision. To be clear, this does not mean we see CPI doubling in 2012 from a present 2.5 percent rate. Our thesis remains focused on the trajectory of inflation over the long term and our concern in the near term is that a 50% increase in inflation as defined as CPI would provide an awakening and shock to many investors who think inflation is under control.

We think that global central bankers do not want to come out and say it, but because some global inflation is a good thing it becomes circular and self fulfilling. We should be thankful that the central bankers at the Federal Reserve heroically stepped up in 2008 and stabilized the economy, but to think there will be no consequences to such actions seems a bit naive. To us it seems like the country is playing hot potato with the debt burden that has been created in this country. It is difficult to see how the balance of power can continue to shift in our favor. Yesterday’s euro issue could become tomorrow’s gold standard. China is telegraphing concerns about possibly needing to divest from their $2 trillion and the impact of such a sale could be catastrophic to our economic position and the dollar.

Again, the key to projecting inflation trends being higher in the future is the fact that we live in a more global world than ever before. And in the future, the dependence on emerging market economies will only become greater. While the dollar remains the reserve currency in the world today, we are also the largest debtor nation, with a real dependence on nations like China and Japan funding our excesses. This problem sets up for a real cost of capital issue. Recently, the S&P put American sovereign debt on negative watch, something that we view simply as a warning sign. For the next few months there is going to be a big debate about how we remove QE2, and whether or not the debt ceiling has expanded. All of these headlines will look scary, and all of the political feuding will be worked out, but the message will remain the same; we cannot expect to continue to borrow at current ridiculously low levels. Foreign loans to the US won’t retire themselves, and we have to question the sincerity of central bankers who claim that they have this situation under control, specifically the inflationary situation [also see Forget The Inflation/Deflation Debate The Real Threat Is Biflation].

We are simply dealing with too many uncontrollable variables, and to think that as borrowers we can control each incremental change in a pyramid scenario is simply naive or arrogant. Going back to our example of Polaroid versus digital, technology and globalization has accelerated the pace at which change happens. Moreover, each country has a different agenda that is based upon its own people’s needs, but across the emerging markets wages need to increase. We live in a global world and each individual government’s priorities will be different, but Americans need to face certain realities. According to the World Bank, in 2030 15% of the middle class will be from emerging markets which is over double the 6% calculated in 2005. When was the last time we looked at a product “made in China or Asia in general” and said wow I really am glad that minimum wage went up for those people so I can pay more for this item. In the Middle East, as a result of promises made by the Royal families to improve the standard of living for their people, the base price for oil is something like 20% higher. Indian wholesale prices rose to nearly 9% year over year. These are realities that will filter through our economy and affect the long term outlook for America’s inflation rate.

Don’t get me wrong. I am optimistic about our country’s prospects, but we need to deal with reality and how we lead as a developing nation. Now I know that 20 years in the future seems like a long time, but I would rather be dealing with an inflationary outlook based upon current and future statistics, rather than looking at CPI at a picture taken from a Polaroid camera.

Check out part two of the interview here, picture number one is courtesy of Toni Rantanen.

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